The penalties, while something to think about, are not terribly onerous. “With a few exceptions, such as when the beneficiary receives a scholarship, the earnings portion of non-qualified withdrawals will incur federal income tax as well as a 10% penalty. You may also owe state taxes if you claimed a deduction or credit for your contributions.”
Note that it is only the earnings portion. Paying the federal income tax is a no-brainer, since you can’t get that benefit unless it is for education. So the 10% on EARNINGS is the only real penalty. So sure, you don’t want to do this not expecting to use it for education, but it is not an unreasonable hit.
Get debt paid off, put away money for an emergency fund, max out retirement plans then set aside money for your children’s education. You need to take care of yourself financially first then you can make life cheaper for your kids. They have more time to deal with education expenses than you do. If you do have the money then I recommend a 529 plan. We use Vanguard target graduation date account. The money gets put into safer funds as your child gets closer to graduating from HS. I understand MiamiDAP’s situation. She is correct that if your child doesn’t go to college there will be penalties to use the money. The problem with withdrawing or borrowing from a 401k is that it still must be paid back and you have reduced your retirement saving substantially.
Miami- you have an MBA, no? Surely you can calculate the opportunity cost of pulling money OUT of a 401K and losing all of the appreciation you would be getting if the money were there. And you can also compare the interest rate your funds got once you liquidated an investment to pay for med school (you can’t pay for med school with shares of an index fund or shares of Microsoft- you need to sell your stock, stash the proceeds in a money market account earning less than 1%) vs. keeping the funds working for you.
So you don’t just lose the actual cash that you pull out- you lose the imputed growth/capital gains the funds WOULD have been earning had you left them in there.
That’s why it’s not a good idea to fund college expenses out of a retirement account. You can borrow from yourself, but you’re taking a haircut in the years right before retirement to do so.
got it?
That’s why a 529 FOR MOST PEOPLE is going to be a better vehicle. You know the year your kid becomes a Freshman so you plan to shift from high growth investments to less risky investments once the kid hits HS. And if your kid doesn’t go to college at all- which for most people planning and saving isn’t very likely- you can use the funds for another person’s college education with zero penalty, i.e. a grandchild.
And for many people- having a mortgage right now and investing what they would have used to pay off the mortgage in a high growth vehicle- is a very, very smart people. Not everyone- but for many people. If you have a low interest rate and itemize; if you are disciplined about your investments and don’t churn your account- you can do much better after tax by NOT paying off your mortgage.
I still would open the 529 ONLY after maxing out on 401k and paying off my mortgage. Otherwise, the 529k does not look beneficial to me in comparison to 401k. If you reach the legal max on 401k and paid off your mortgage and have money left, then I may consider 529 or any other savings. We did not have to think about 529 or any other savings for this matter, since we did not have money left for them. This is very simple and straight forward to me as far as my own MBA (which was NOT in finance) as well as my H’s MBA (which is fact was in finance). We would not withdraw from the 401k with penalty either, we waited until we were old enough to withdraw without penalty and currently we are very close to the age when we have to withdraw anyway, so what is the point of not withdrawing? As I said our specific situation is not applicable to everybody else. However, no matter what you do, you got to research your options very closely and apply your own situation to them. If 529 makes sense to you, go for it!! Many people simply do not have this option, they do not have any money for 529 just like our family. Not paying off mortgage would be an option if we had 2%, but we did not. If you have a mortgage, then you are paying much more to the bank in interest then you save in taxes. So, not paying off the mortgage was not our option either, while it could be a good option for somebody else.
Do not try to wear somebody’s hat, most likely it will not fit. This I can tell with great certainly and it is applicable to much wider aspects of our lives than just financial. So there is no arguments, this is just a collection of information and we can only advise based on our own personal experience.
Let’s take the 401(k) penalty free withdrawal off the table since the OP will not be old enough when his first born goes to college.
Regarding paying off the mortgage- There is an entire field of behavioral finance for a reason. Personal finance is not just math. While Betty may be able to sleep at night with a mortgage payment due, her husband’s job a little shaky and the stock market tanking, Mary may not be able to. Risk is an essential element in all financial problems. And most people are bad at estimating risk- some underestimate it and lose the opportunity to make money and some overestimate it and lose money.
We did a prepaid 529, a 529 savings plan (at the time Utah had the lowest fees and we get no state income tax deduction), and a separate investment account for the non-QEEs. I pegged our savings to the state flagship’s COA which I have been watching for 8 years now.
Now that he is enrolling there, our biggest lesson is that while he can live in the dorm that is represented in the COA, we don’t expect him to. So we under saved for that but it is a few thousand dollars difference that we are choosing to spend.
You’ve gotten some good financial advice above. One thing that I didn’t realize before having kids was HOW expensive sports/activities/music or daycare/summer/after school costs were. It’s a good idea to talk to your spouse ahead of time regarding school districts, private/public, and the like. Lots of cash can flow down creeks you never knew existed.
Check to see if your state had tax advantages for 529s. If so, go with your state plan. Our state (CA) doesn’t have such advantages, so we went with another state’s plan. We went with one that had good investment options, low expenses, and was managed by a large brokerage (Fidelity) that we already had a rollover IRA with. There should be websites that compare the current state 529s.
One thing I wish I’d noticed a bit earlier is that the graduation year based investment portfolios are very conservative even in the early years. We are somewhat aggressive investors, and when I noticed the asset distribution, I moved the funds, which were about 1/2 bonds with 15+ years until college, to regular stock index funds. Of course, past performance is not an indicator of future results…
Ynot- excellent advice. My company offers employees a free sit-down with an expert investment adviser to evaluate their 401K options based on their age, number of dependents, lifestyle, risk profile, other assets in their portfolio and we are consistently amazed by two things:
1- A high percentage of folks don’t take advantage of the service (it’s free and nobody is selling you anything- just advising you on how to allocate the funds already in your account).
2- A high percentage of folks have very conservative portfolios, even when they are quite young; even when they’ve already got their emergency funds, have adequate life insurance, have solid income prospects, etc. Why a 28 year old with no student loans and no dependents is investing like a 68 year old widow confounds the experts!
Well, fixed income investments have such low returns right now, they really are worthless, no matter what your age is. They barely keep up with inflation so one’s “real” return might even be negative.
But, what’s funny is that equity investments have had two biblical declines in my lifetime alone. We had the early 2000’s tech bubble burst which was the first once every 100 years flood type event wherein equities got destroyed in a very short time frame and it took close to a decade to recoup those losses.
Then we had the 2008 credit crisis thing which lead to another massive decline in value. In theory, the more risk you take the higher return you should get to compensate the investor for all that extra risk, right? Well, that hasn’t worked out particularly well in my lifetime and I think many people under a certain age don’t trust equity investments. I think they prefer to invest in safer things regardless of the lower returns and/or commodities and/or start their own businesses and/or just spend it instead of invest it.
A lot of good books on behavioral finance. Any expert advising people who understands the psychology of investing should not be confounded. Given the life experiences of today’s 28 year old with the financial markets, they are likely to be more conservative than today’s 68 year old. It would be very difficult to convince them to invest based on math alone and given what they have seen, they are going to be predisposed to overestimate risk for most of their lives just as today’s 68 year olds are predisposed to underestimate it based on their experiences.
And don’t underestimate the time factor and compounding interest in conservative 529 plans. I wish I had been able to save more in my child’s first years.
re: risk tolerance. We are pretty risk tolerant, and had our 529s in “aggressive age-based”. They took a huge hit in 2008 of course. Our first kid went to college in 2011. We let it ride, and by the time she went to college, her 529 was back up (significantly) over our contributions. I think the funds do a pretty good job of judging the mixes, and at least in our state (NY), we were able to choose the risk of the age-based from three choices.
Getting schooled- I am being facetious, of course. The experts understand the psychology of millenials and their attitudes towards risk, consumption, savings, etc. But regardless of what the market has done in your lifetime, or is doing now, the fact remains that learning to save in your first and second job is likely a better predictor of a secure retirement than many of the other metrics. A young person with a good job, very little debt, and no dependents, ought to be able to accumulate some capital- whether invested aggressively or not- especially with a company match (otherwise known as free money). It is hard to make up for lost time when you are 45 and you’ve spent your extra assets (beyond paying for a place to live, food, transportation, charity, etc.) on trips to Cambodia and long weekends in Costa Rica. We’ve got reams of research on how millenials value experiences more than things- which is a wonderful hallmark of many (not all) of this cohort. But underestimating the impact of savings in your 20’s (if you can) is a mistake.
My spouse bugged me about looking into 529 plans when our first kid was born.
For various reasons, we just did not get around to pick a plan and participate in it.
Looking back, this may be a blessing in disguise.
With my financial acumen, I probably would have done poorly here as I have in my 401K.
Between the 2000 tech crash and the 2006 financial market crash, my 401K has performed rather pitifully.
So, we are a pay-as-you-go family with 2 kids in college - it is amazing how much college can cost in this country. :((
I’m a little late to this thread but want to emphasize one thing. Do not tap a 401k for student/college expenses. A 401k or 403b is for one thing only: to build a retirement fund for you and your spouse. It’s good that the OP is maxing this out now, but he and spouse should continue to do that.
When my kids were approaching college the 529 plans were a new thing. We didn’t use them. We set aside cash in good old savings accounts, earning nominal interest. (We – the kids – also had some EE bonds gifted to them by their grandparents.) The advantage of a 529 plan is that you can invest in it much like you do with your 401k, and there’s greater possibility for appreciation. The earlier you start, the better. Nothing like 17-18 years of accumulating and growth.
Like @scout59 I also hope you enjoy every moment of being parents. You won’t, of course, but watching and helping kids learn and grow is just an amazing thing. You’ll see their personalities very soon after birth. What they might become later is an adventure for sure. When our first child was born, my wife’s grandmother offered simple advice: “Just bring them up alive.” Of course she was from a generation born before we had all these prophylactic and curative medicines. But there’s still an elemental truth to her advice. I would say, “let them live” and develop according to their own personality and nature; you can feed them, keep them safe, and offer opportunities, but you never quite know how they’ll turn out.
I agree with others to focus on paying down high interest debt first (CC, student loans), especially while your wife is still working, I assume she will want some time off once the baby is born.
Contributing the amount of employer match to 401k is fine. Also life insurance is important, but term life is pretty affordable for young people. Emergency savings is important, especially if going from two income to one.
Once the higher interest items are paid off, you can focus more on college savings and increase retirement savings.
I don’t have experience with expensive private school tuition. The public schools might be just fine depending where you live.
Nothing to add @bigredmed but I did want to say welcome back and thanks for everything you did on CC when you were here. I thought it was amazing how much info you shared with kids and parents as you went through the process of education.
Congrats to you on your great accomplishments and the wonderful family that you have!!